The Great Pension Robbery
Forfeiture rules adopted by private pension plans can unfairly deprive employees of benefits crucial to their long-term security.
Question 7. Ask the Candidate:
Shouldn’t an employee’s pension be protected after he or she has been employed for three years?
Congress provides highly favorable tax breaks for pension plans and participants in order to promote the retirement savings of ordinary workers as well as management. But what it gives through tax breaks can be taken away through brutal forfeiture provisions.
The Deadly Forfeiture Rules
Because annual contributions to their accounts are likely to be modest, ordinary workers must accrue benefits early and often if they are to achieve a decent retirement income. Fortunately, workers may never forfeit pension accounts funded out of their own wages, as in 401(k) plans. That’s not true of contributions by employers to 401(k) plans or to other, traditional pension plans: These contributions can be, and almost always are, subject to forfeiture rules that can cause an employee to lose everything.
Say you’re in your 20s and have been hired by a large corporation. You expect to work there for three years and then might move back to your home state. You’re told that after you’re employed for one year, the corporation will contribute an amount equal to 7% of your salary to a pension account for you. The contribution will be in addition to your salary and other benefits. That evening, you thumb through a thick, glossy brochure describing the pension plan and discover that the contributions, which you pictured as a form of compensation, won’t do you a bit of good. If you stick to your schedule, you’ll forfeit your entire pension account.
Forfeiture rules apply even if you are fired without cause.
Employers like forfeiture provisions in pension plans because they encourage workers to stay and penalize those who quit or are fired. Congress always has indulged employers’ desires here. Until 1974, an employee who spent her working life with a company could forfeit her entire pension—100% of it--if her employment terminated for any reason prior to her normal retirement age, which usually was 65. The Pension Reform Act of 1974 at last set “limits” on forfeitures, but still allowed 100% of an employee’s pension to be forfeited if her employment lasted less than 10 years, or part of the pension to be forfeited if her employment lasted less than 15 years.
Pension plans could prohibit any forfeiture, if employers wish. They rarely do.
Forfeiture provisions today are less harsh but still excessive. Here are thetwo most common ones chosen by private employers as permitted by the Internal Revenue Code.
Cliff Vesting. In “5-year cliff vesting,” an employee loses her entire pension if her employment terminates before she has been employed for five years, even if she falls short by only one day and is fired without cause. In other words, her pension “falls off a cliff.” Congress allows such forfeitures although they know that employees commonly change jobs in less than five years; particularly young people and unskilled workers.
Graduated Vesting. The other common forfeiture provision involves a graduated schedule that looks like this:
|Years of Service||Forfeiture|
|Less than 3:||100%|
|3 up to 4||80%|
|4 up to 5||60%|
|5 up to 6||40%|
|6 up to 7||20%|
Under this schedule, if you’ve worked for 2 years and 11 months when your employment terminates, you forfeit everything. Even if you’re fired without cause during your sixth year, you will forfeit 40%.
If you’re young and lose your pension after a number of years with a company, sure, you’ll feel bad. Chances are, however, you think you can make up the loss by saving extra amounts in later years. But the early losses are difficult to overcome—particularly for ordinary workers. Because employer contributions typically are defined as a percentage of wages, these workers never have large annual sums contributed to their accounts. Still, saving for retirement as early as possible and without forfeitures makes it possible for savings to grow in value (to “compound the interest”) year after year. Given enough time, the effect of compound interest can be dazzling.
While 7% compound interest looks unrealistic today, it was commonly achieved in prior decades and we can hope will become realistic in the years ahead.
Consider Ms. Early. She’s 22 years old and works for Goodguy, Inc., which promises to contribute $1,000 to her defined contribution pension account each year of her employment. If she works for 43 years until she is 65, Goodguy will have contributed $43,000. If each year’s contribution earns 7%, what will be the size of her account when she is 65? How about $265,000!
Now consider Ms. Late. She’s 22 and works for Badguy, Inc. Badguy also promises to contribute $1,000 to her defined contribution pension account each year of her employment. But a few months before she had worked there for five years, she was fired and lost her entire pension under the pension plan’s 5-year “cliff” vesting schedule. She then bounced around among various jobs, each time forfeiting her pension contributions until, at the age of 32 (10 years after Ms. Early), she, too, was hired by Goodguy.
For 33 years, until she was 65, Goodguy contributed $1,000 each year to its pension plan for her, which also earned 7% per year. What do you think those $33,000 of contributions were worth when she reached 65? Only $127,000.
In other words, Goodguy’s contributions for Ms. Early were only $10,000 more than they were for Ms. Late, but Ms. Early’s pension account was more than twice as large. That’s because her contributions had an additional ten years to compound the rate of return. Yes, Ms. Late’s forfeiture under Badguy’s plan really hurt.
On the other hand, Ms. Late is more fortunate than many others. As mentioned in Question 6, at least 40% of all people 65 and older receive nearly 90% of their income from Social Security because their pension, IRA, and investment income is so small.
What Congress Should Do
Congress should reform the pension tax laws to prohibit the forfeiture of more than 50% of pension accounts after an employee’s second year of employment, and prohibit all forfeitures after the third year.
While companies like to use forfeiture provisions to advance their own interests, Congress has an obligation to promote the public interest by strictly limiting forfeitures. We are ill-served when forfeiture provisions discourage employees from leaving one company for a more promising, higher paid job. And it never can be in the public interest for workers to forfeit their pensions when they are fired without cause.
Economists make another crucial point: Employees pay indirectly for most of the pension contributions made by their employers. That’s because employers usually reduce their employees compensation or fringe benefits in light of the pension contributions. Seen this way, the money lost by an employee when she forfeits her pension account is largely her own money.
This limited forfeiture rule still would offer some protection to employers from potentially costly short-term employees. On the other hand, more restrictive limitations on forfeitures would make the rest of us less vulnerable to the risk that we may be called upon to pay extra taxes to assist these workers in their retirement.
There’s one sure way to know where a candidate stands on this question: Understand the “rule of the second clause” in politics, which a cousin steeped in politics explained to me when I moved to Washington, D.C. The second clause tells us everything. For example, if a candidate says, “No one cares more deeply about the long-term security of the American worker than I do, but (now really pay attention) we need to take into account the interests of employers as well.” Sure we do. And we’ve just learned how he’ll vote.